Download AD and AS - uwcmaastricht-econ

Demand-side and
Supply-side policies
Demand-side policies



Based on the idea that short-term fluctuations
of Real GDP are due to actions of firms and
consumers that affect AD, causing inflationary
and recessionary gaps.
Objectives: bring the AD to the FE level of Real
GDP.
D-side policies can also impact on economic
growth, that is, increase potential GDP (shift
LRAS curve to the right). IB exam question of this
year!!
Fiscal Policy (FP)



Definition: manipulations by the government of
its own expenditures and taxes in order to
influence the level of AD.
Government receives revenues from income and
business taxes, T.
Government expenditures: G
If G=T: balanced budget
 If G>T: budget deficit Gov needs to borrow
 If G<T: budget surplus


Public/Government Debt is the gov’s
accumulation of deficits minus surpluses.

FP can affect AD through 3 components:
G. Direct impact on AD
 C. FP, through changes in income taxes, affects the
disposable income of consumers, which affects their
consumption expenditures.
 I. Through changes in business taxes, FP affects the
after tax profits of firms, which has an impact on
their level of investment expenditures.

Expansionary Fiscal Policy


In a recessionary gap (Y<YFE), the gov can
increase AD with expansionary FP, which
works to expand the level of economic activity.
Expansionary FP can consist of:
1.
2.
3.
4.
↑G
↓ personal income taxes
↓ business taxes
a combination of the three.


An increase in G has a direct impact on AD
A decrease in T affects AD in a 2-step process:
↓T → ↑Disposable income Yd / ↑After-tax businesses profits
→ ↑C / ↑I → ↑ AD


The increase in real GDP will be smaller in the
neoclassical model than in the Keynesian one,
because of the upward sloping neoclassical AS curve.
The increase in the PL will be smaller in the
Keynesian model, where the increase in AD may
result in no increase in the PL at all if the AD shift
occurs entirely within the horizontal segment of the
Keynesian AS curve.
Contractionary Fiscal Policy


In an inflationary gap (Y>YFE), the gov can
decrease AD with expansionary FP, which works
to contract AD and the level of economic
activity.
Contractionary FP can consist of:
↓G
2. ↑ personal income taxes
3. ↑ business taxes
4. a combination of the three.
1.


A decrease in G has a direct impact on AD
An increase in T affects AD in a 2-step process:
↑ T → ↓ Disposable income Yd / ↓ After-tax
businesses profits → ↓ C / ↓ I → ↓ AD

Figures 9.1 and 9.2.
Monetary Policy (MP)



Carried out by the Central Bank (CB) of each
country.
The CB is a (government) financial institution
whose purpose is to control the supply of
money, determine the rate of interest, oversee
the banking system and carry out monetary
policy.
In the countries which form the European
Monetary Union (EMU), monetary policy is
carried out by the European Central Bank
(ECB), located in Frankfurt.



MP impacts AD indirectly through the rate of
interest.
Interest is the payment (per unit of time) for
the use of borrowed money. Usually expressed
as % of the principal to be paid per year. This %
is called the rate of interest.
The money market is a market where the
demand for money and the supply of money
determine the equilibrium rate of interest.
The rate of interest is the price of money services.
 The Demand for money is downward sloping.


Why is Dm downward sloping? (Fig. 9.3)
Money allows economic agents to carry out their
buying and selling exchanges.
 Money can be used as a form of saving when used
to buy bonds (a certificate issued by the gov or a
firm that promises to pay interest at various intervals
until the date when the money is repaid to the bond
holder).
 So, interest is the opportunity cost of holding
money, as you could have received that interest if
you had saved the money instead of holding it.
 The higher i, the higher the opportunity cost of
holding money and the lower the quantity of money
demanded.




The Supply of money, Sm, is fixed at a level that
is decided upon by the CB. Sm does not depend
on i.
Monetary policy is carried out by the CB,
through changes in the money supply, which are
undertaken in order to influence the rate of
interest: ↑Sm → ↓ie ↓Sm → ↑ie
In practice, the CB can target either the money
supply or the interest rate. Most central banks
target the interest rate: decide upon i and then
adjust Sm so that the actual ie will become equal
to the target i.

Changes in i affect two components of AD:
C, as some consumption is financed by borrowing.
 I, as firms borrow money in order to finance their
investment expenditures.
 Therefore:
↑ i → ↓ C , ↓ I → ↓ AD and AD shifts left
↓ i → ↑ C , ↑ I → ↑ AD and AD shifts right

Expansionary (easy money) Policy



In a recessionary gap (Y<YFE), the CB increases
Sm, causing the interest rate to decrease.
A lower i means a lower cost of borrowing, so
consumers and firms are likely to borrow and
spend more: ↓ i → ↑ C and ↑ I → ↓ AD.
I is more sensitive than C to changes in i, so the
increase in I will have a greater impact on AD
than the increase in C.
Contractionay (tight money) Policy



In an inflationary gap (Y>YFE), the CB
decreases Sm, causing the interest rate to
increase.
A higher i means a higher cost of borrowing, so
consumers and firms are likely to borrow and
spend less: ↑ i → ↓ C and ↓ I → ↓ AD.
I is more sensitive than C to changes in i, so the
increase in I will have a greater impact on AD
than the increase in C.
Strengths and weaknesses of D-side
policies for short-term stabilization
Strengths of Fiscal Policy
1.
2.
The strength of FP is to pull an economy out
of a deep recession, or when the economy
finds itself in the horizontal segment of the
AS curve. Remember Keynes and the Great
Depression of the 1930s!
Combating rapid and escalating inflation.
Weaknesses of Fiscal Policy
1.
Problems of timing. FP is subject to time lags:



A lag until the problem is recognized .
A lag until the appropriate policy is decided upon
by the gov.
A lag until the policy takes effect in the economy.
By the time the policy has taken effect the
problem may have become less or more severe,
so that the policy is no longer the appropriate
one.
2.
3.
Problems of inadequate information. The gov
relies on statistical information and forecasts
for its policy decisions. Inaccuracies may then
lead to inappropriate policies.
Political constraints. Gov spending and
taxation are subject to numerous pressures that
are unrelated to fiscal policy considerations.
Spending in public and merit goods is
undertaken for its own sake and cannot easily
be cut. Taxes are politically unpopular and
might be avoided even though they might be
necessary.
4.
5.
Crowding-out effect. The increase in interest
rate caused by deficit spending can lead to lower
investment spending by private firms. A
greater G is offset by a lower I.
In a recession, tax cuts may not be very
effective in increasing AD. Part of the increase
in after-tax income is saved. If this share
becomes larger due to pessimistic future
expectations, the impacts of tax cuts on AD
will be even weaker.
6.
Inability to fine tune the economy. FP can lead
the economy in a general direction of smaller
or larger AD, but it cannot be used to reach a
precise target with respect to the level of
output, employment and the price level. It is
not possible to use FP to keep real GDP at or
very close to its potential level. There are many
factors affecting AD that the gov cannot
control.
Strengths of Monetary Policy
1.
2.
Quick implementation. MP can be
implemented more quickly than FP because it
does not have to go through the political
process.
No political constraints:


MP not subject to political pressures, does not
involve changes in gov budget.
CB in many countries is independent of the
governing political party.
3.
4.
No crowding-out effect.
Better suited to fine tuning of the economy in
comparison with FP. Above factors make MP
more accurate wrt achieving output, price level
and employment objectives. However, also
subject to limitations.
Weaknesses of Monetary Policy
1.
Problems of timing. Although MP does not
depend on the political process, it is still
sunject to time lags:


2.
A lag until the problem is recognized .
A lag until the policy takes effect in the economy.
Changes in interest rates can take several months
to have an impact on AD, Y and PL. This time lags
becomes longer if there is pessimism in the
economy.
Problems of inadequate information.
3.
Possible ineffectiveness in recession. A tight
money policy can effectively combat inflation.
However, an easy money policy is less effective
in a deep recession. In a recession, lower
interest rates would encourage C and I,
increasing AD. This is under the assumption
that banks will be willing to ↑ their lending to
households and firms and that these will be
willing to ↑ their borrowing and their
spending. However, in a severe recession banks
may be unwilling to ↑ their lending and if
firms and consumers are pessimistic about
the future they may avoid taking new loans and
may even ↓ their I and C. This situation
occurred in the 1930s and there were fears that
it would occur in 2008.
Weakenesses of both

If the economy is experiencing stagflation
(↓Y+↑PL), neither FP or MP can bring the
economy back to the macroeconomic
equilibrium. These policies cannot resolve both
inflation and UE at the same time.
Inflation requires a contractionary policy
 UE requires an expansionary policy

Fiscal or monetary policy?
 Keynesians believe that FP is more effective in
achieving stabilization.
 Neoclassical economists have believed that MP
is more effective.
 Today economists agree in that they are most
effective when used together.

According to most economists:
because of its greater speed and flexibility, MP is
better suited to dealing with short-term stabilization,
particularly when there is an inflationary gap.
 FP should focus on creating a stable fiscal
environment, involving avoidance of very large and
persistent budget deficits or surpluses.
 FP should be used to complement MP in the event
of strong economic downturns to prevent a serious
recession, or to pull an economy out of a serious
recession (autumn 2008).

D-side policies and long term growth
D-side policies can contribute to ↑ the level of
potential GDP in two ways:
1. Indirectly, by providing a stable
macroeconomic environment in which
consumers and firms can plan and carry out
their economic activities.


Firms must make decisions on investment in
capital goods and whether, how and in what areas
to pursue R&D and technological innovations.
Both the formation of capital goods and
technological changes are important factors in
increasing potential GDP.

2.
In order to be able to plan over long periods of
time, firms need economic stability, ie, avoidance
of sharp economic upturns (inflation) and
downturns (recession and UE).
Directly (Figure 9.4):


By encouraging investment through lower business
taxes (FP) or lower interest rates (MP), thereby
contributing to new capital formation and
technological innovations that increase YP.
By directing a portion of G
a.
b.
c.
to the development of infrastructure (roads,
telecommunications,...) which increases the quantity of
capital goods.
On R&D, which increases technology.
On training and education, that increase the quality of
the labor force and can also help lower the NRU.
Supply-side policies


Objective: shifting the LRAS curve (not the
SRAS!!), in order to achieve long-term
economic growth.
Two types:
1.
2.
Market-oriented, favoured by neoclassical
economists, who emphasize the importance of
well-functioning competitive markets in bringing
about shifts in the LRAS curve.
Interventionist, favoured by Keynesians. They
attempt to increase LRAS by relying on gov
intervention, rather than the market.
Market-oriented S-side policies


Early 1980s, some neoclassical economists in the
UK and the US emphasize the importance of
the supply-side of the economy in the growth
of real GDP. Margaret Thatcher and Ronald
Reagan adopted this view.
Since real GDP tends automatically (according
to the neoclassicals) towards long-run FE
equilibrium, the focus of gov policies should be
less on stabilization and more on achieving
increases in potential output (shifts of LRAS).
Theoretical justification


An economy pursuing S-side policies will be able
to achieve rapid growth, price stability and FE
at the same time. The reason is that a stable price
level and FE are expected to follow as a
consequence of policies that promote growth (ie,
increasing AS).
In the neoclassical view, inflationary and
recessionary gaps are automatically eliminated.
Therefore, as long as the economy can move from
one long-run equilibirum to another, there will be
no UE.



If increases in AS match increases in AD (Fig. 9.4)
the price level does not need to increase. Therefore
economic policy should focus on increasing AS
(shifting both LRAS ans SRAS) so that this will at
least match increases in AD.
Increases in AS may address the problem of
stagflation, which D-side policies cannot correct.
(Page 262, Fig. 9.5).
S-side policies may aim at:
1.
2.
3.
4.
Reducing the size of the gov sector and increase
competition.
Improving incentives by lowering taxes.
Making labour mkt more responsive to S and D.
Liberalizing international trade and capital flows.
1. Reducing the size of the gov sector and
increasing competition
 Rationale: a large gov sector may be inefficient
(admin costs, unproductive workers,
burocracy), as govs do not face incentives to
maximize profits.
A. Privatization. Leads to increased efficiency.
B. Private financing of public sector projects. A
private firm undertakes to build, finance and
operate public services and the gov buys the
services from the private firms. Increases
competition, efficiency and quality.
C.
D.
Contracting out to the private sector
(outsourcing). Increased competition, improved
efficiency, lower costs and improved quality.
Deregulation. Elimination or reduction of gov
regulation of private sector activities.


Economic regulation: government control of
prices and output, which offers firms protection
against competition. Ex: transport, airlines, tv
broadcasting, electricity,...
Social regulation: protection of consumers against
undesirable impacts of private sector activities in
areas like food, pharmaceuticals, worker protection
agains injuries and pollution control. Some
economists argue that social regulation is excessive.
E.
Restricting monopoly power can result in
increased competition, greater scope for the
forces of S and D, increased efficiency, lower
costs and improved quality. Ways of restricting
monopoly power:



By enforcing anti-monopoly legislation,
By breaking up large firms wngaging in
monopolistic practices into smaller units,
By preventing mergers between firms that might
result in excessive monopoly power.
Strengths of these policies. Reduction of gov
control of economic activities and the transfer
to the private sector can give rise to more
competition, greater efficiency and lower costs
of production, with possibly increased quality
of goods and services.
Weakenesses

Privatization. A public monopoly may become a
private monopoly. Private firms are likely to ↑ prices,
which may damage lower income groups. There may
also be negative effects on employment if private
firms lay off workers when trying to cut costs.

Private financing activities.
Prices might be higher than when the government is the
provider.
 Loss of gov control over the project and reduced project
flexibility.
 The concern that firms may not pay sufficient attention to
population safety needs and that these may be sacrificed
as a consequence of trying to keep costs low.


Outsourcing.
Loss of flexibility to respond to changing market
conditions.
 When outside firms are involved: loss of internal talent
that could have been used, gov job losses and job losses
for the country as a whole.


Deregulation.
Sometimes leads to higher prices and lower quality
services.
 Frequently led to increased UE, due to increased
competitive pressure.
 The financial crisis led to broad recognition of the need
to increase the regulation of financial services, as well as
to a partial nationalization of some financial services
institutions.
 Social deregulation is unlikely to be in the public interest.

2. Improving incentives by lowering
taxes
1.
Lowering personal income taxes. The gov can
↑ or ↓ personal income taxes as part of fiscal
policy, thereby ↓ or ↑ AD. S-side economists
argue that changes in income taxes have an
even greater impact on AS. They claim that tax
cuts will give rise to higher after-tax incomes,
and this is an incentive for people to provide
more work. This can happen through




↑ number of hours worked
↑ number of people interested in finding work
↑ number of years worked.
↓ in UE, as unemployed workers choose to
shorten the duration of their UE.
All these factors may work to shift the LRAS
curve to the right.
2. Lowering taxes on interest income (taxes paid
on income received from interest on savings
deposits). This will increase incentives to save,
increasing the funds available for I, which will
increase the production of capital, which
increases potential output.
3.
Lowering business taxes increases AD by
increasing I. S-side economists argue that this
is a S-side measure, since the increase in aftertax profits increases the financial resources of
firms to produce new and improved capital
goods and pursue technological innovations.
Both these effects increase potential output.
Strengths of these policies. If they work as
intended, tax cuts would give rise to:
increases in the quantity of labour and capital
resources,
 a reduction in UE,
 increased saving,
 increased I and
 more R&D and technological innovations,

All of which contribute to increasing YP.
Weaknesses of these policies.



Some economists argue that tax policies may have a larger
impact on AD than AS. Income tax cuts may result in people
supplying less work if they decide to use their extra after-tax
income to increase their leisure time. Also, consumers may
decide to use their higher disposable income to consume
more rather than to save, which will have an impact on AD.
Tax cuts may give rise to increasing inflation. If the impacts
of tax cuts are greater on AD than on AS, then they may
create inflation.
They may worsen income distribution, as it is the wealthy
who earn most of the interest income and business profits,
and therefore these tax cuts will affect wealthy people by
increasing their after-tax incomes more then they will affect
theo other population groups.

Tax cuts are likely to increase gov’s budget deficit
unless they are accompanied by decreases in gov
spending. But decreases in G (contractionary FP)
may not be appropriate if the economy is
contracting (downward phase of the business cycle).
Tax cuts were implemented in the 1980s in the Uk and
in the US, but economists disagree on whether or
not these have worked to increase YP. The reason is
that whatever growth has occurred has been the
result of both D-side and S-side effects of D-side
and S-side policies, being very diffciult to isolate the
effect of a particular policy.
3. Increasing labour market flexibility
1.
2.
3.
Abolishing minimum wage legislation, so that wages
become more flexible in the downward direction. The
effects will be lower UE, greater firms profits (labour
costs are lower) and increased capital goods
production and economic growth due to increased
firm profits.
Weakening the power of labour trade unions, so that
wages will be more responsive to S and D. Same
benefits as above.
Reducing UE benefits, which are argued to have the
effect of lowering the incentive to search for a new
job. The effect would be lower UE.
4.
Reducing job security (laws that protect workers
against being hired making it costly for firms to fire
workers). It is argued that firms would be more likely
to hire new workers if they know they can fire them
easily and without cost when they are no longer
needed. Also, reducing job security would decrease
firm’s labour costs, increasing profits.
Strengths of these policies.

If wages can fall when there is UE, this will reduce
firms’ costs of production and give rise to increased
profits, higher employment and profits.
Weaknesses of these policies.
Some economists argue that paying workers a higher
than equilibrium wage encourages them to work
harder, increasing their productivity, which increases
demand for labour (↓ UE).
 These policies involve changes in legislation that
provide protection for workers with very low
incomes. Reducing protection results in lower wages
and job insecurity, increasing income inequalities.


UE benefits can play an important role in a
recession, as they compensate for the loss of income
of the unemployed, helping maintaining the level of
consumption spending
4. Liberalizing international trade &
capital flows
Freer trade and freer capital movements between
countries increase global competition,
improving the allocation of resources within
countries and globally.
Interventionist S-side policies

1.
They presuppose that the free market
economy cannot by itself achieve the desired
results in terms of increasing potential output.
Therefore, gov intervention is necessary in
some areas:
Public training and education programmes
can provide skills to workers, which may
become more employable and more
productive. This also improves the quality of
labour resources, increasing production
possibilities.
2.
3.
Improved health care services and access to
these, which leads to improvements in the
quality of labour services.
R&D makes technological advances possible,
and these are a very important factor behind
increases in potential output and economic
growth. Gov in many countries are involved in
R&D and, in addition, they provide incentives
to the private sector to engage in R&D (tax
incentives, granting of patents).
4.
5.
Provision of job information (employment
agencies), which decreases the time the
unemployed spend trying to locate jobs,
helping lower the level of UE.
Support for small and medium-sized
enterprises (SMEs), in the form of tax
exemptions, grants, low interest loans and
business guidance. This promotes efficiency,
more capital formation, more employment
possibilities and therefore increases in
potential output.
6.
7.
Support for ‘infant industries’. These are
newly emerging industries (in developing
countries) which sometimes receive gov
support (grants, subsidies, tax exemptions,
export protection). This also provides support
for growth of the private sector.
Improvements in infrastructure, which
decrease production costs. Infrastructure is a
type of physical capital and includes power,
telecommunications, roads, dams, urban
transport, airports and ports.

Strengths of industrial policies. (Definition:
policies designed to support the growth of the
industrial sector of an economy, shifting the
LRAS curve or the K-AS curve to the right)
1.
2.
3.
They offer opportunities for gov support in
particular areas that would not materialize as
needed if left to the market.
Industrial policies allow the gov to support
particular industries that are believed to offer the
greates possibilities for growth in the future.
A number of policies can be useful in lowering
certain kinds of UE.

Weakenesses of interventionist policies.
1.
2.
Gov interference may lead to inefficiencies and
resource misallocation, whereas reliance on the
market through market-oriented S-side policies will
achieve the desired impacts on long-term growth
while avoiding these disadvantages.
The use of tax revenues for the support of
interventionist activities uses resources that might
have better alternative uses elsewhere. Supporters
of market solutions argue that large amounts of
tax revenues are needed in order to provide all the
support services. This implies high taxes
(disincentive to work) and large gov sector
(promotes inefficiencies).
Interactions between D-side and S-side policies



S-side policies have also D-side effects, for example,
lower income taxes may provide incentives to work
harder and longer, but also, increase consumption
spending.
In the real world, given the complex interactions
between the different polices, it is difficult to identify
what particular policy is responsible for what effect.
Economists generally agree that S-side policies play a
very important role in increasing potential output.
They disagree on:

1.
2.

Whether market-oriented or interventionist policies are
more effective.
The importance of S-side effects of D-side policies in
causing growth. Some economists (Keynesians) argue that
these can be very important, while others (neoclassicals)
argue that they are less so.
Growth in real GDP involves increases in both AD
and AS.